All Things Roth IRA

Roth or traditional investments? This is an age-old personal finance question, and you probably already know that there is no one right answer. Whoever you are, chances are you want to reduce your tax burden — and no one will fault you for that. Financial advisors like the advisors of Correct Capital can help you make sound, personalized decisions regarding your retirement accounts and other investments. Two of our advisors, including 30-year veteran retirement plan specialist John Biedenstein, discuss all things Roth from Roth conversions, the history of Roth, and Roth 401ks versus IRAs.

Hear from the experts about making the right tax arrangement decision for your retirement accounts. For this and other discussions related to retirement, investing, and the financial market, listen to our podcast Capital Conversations or catch our most recent blog posts here.

Below is a transcript of our most recent Capital Conversations podcast episode, All Things Roth.

All Things Roth

Colin Day: Welcome to Capital Conversations. I'm Colin Day. With me today is John Biedenstein. Thanks for joining me today, John. Today's topic: Roth accounts — All Things Roth. The reason I want to talk to you specifically about Roth is because of your background in Roth 401k and some of the ideas that are coming about, especially when we look at the news and financial topics.

One thing that we hear quite a bit from our clients is the conversation around Roth conversions. So let's start by giving a quick, brief history of Roth accounts, so everybody is level set. And then we can talk about some of the things that complicate Roths, not just from the IRA perspective, but from 401k, and then maybe we can go into some opportunities and what we should be looking for in the future.

When it comes to the origins of the Roth account, the reason we say Roth account, as opposed to "post-tax investing," is because of Senator Roth from Delaware. So he came up with another Senator, this idea of an after-tax savings account for retirement purposes back in the eighties. But it wasn't until it was codified in 1997 that we first got the opportunity to invest in a Roth IRA account.

For those of you who have been saving in retirement accounts for years or decades, you might be more familiar with the traditional pretax investing method. I'm going to put money in and claim a tax deduction on the contribution. Eventually, I'm going to take that money out. I'm going to pay taxes on it, but when it comes to a Roth account, you're paying your taxes up front: state and federal FICA. You're paying all that upfront. And in this case, the IRS is saying, "Thanks so much for paying your taxes upfront. We will forgive you from paying taxes on the earnings, provided you meet some qualifications,” the most standard being that you have the account for five years to nine and a half.

Roth accounts are interesting because they offer this great opportunity for investors to put money aside for retirement. First and foremost, allow that money to be invested and grow for the future. It's different from pretax because many investors probably weren't incentivized to get the tax deduction, especially if they're at the beginning of their careers and in a lower tax bracket than where they'll be in the future.

I don't know about you, John. I want to pay as little money as possible to Uncle Sam. Legally, of course, I want to always make sure I'm not skirting the law. But I want to ensure that if there are opportunities for me to save one way or the other, I'm taking advantage of it. So that's why Roths came about when pretax investing was kind of the realm of all retirement accounts pre-1997. So John, when it comes to a Roth in a 401k plan, it's a little bit different from the IRAs. Is it not?

John Biedenstein: It's a little different than IRAs in that some of the requirements are not applied to 401ks. For example, in Roth IRAs, there's an income threshold. If you're above a certain income, you can't make a Roth IRA contribution. That threshold doesn't apply to 401k Roth. As long as your employer plan allows for Roth contributions, you can do that.

Colin Day: Right, and from a contribution perspective, there's quite a difference between what you can contribute to an IRA or the 401k, right?

John Biedenstein: That's correct. Especially if you're over the age 50, you can contribute up to $27,000 in a Roth 401k account, but an IRA account contribution is up to $7,000. So a Roth IRA contribution over age 50 is limited to $7,000.

Colin Day: For many folks, having the ability to contribute to a Roth account in the first place might be stymied by the fact that you, or if applicable, in a joint filing situation, you and your spouse make too much money. You may not be able to contribute directly to the Roth IRA. But regardless of how much money you make, you can still contribute to the Roth 401k.

And, of course, Roth is available outside of 401ks. We use 401k as a kind of terminology for workplace retirement plans. There are, of course, other kinds of retirement accounts available. For example, Roth 403B plans if you work in the government sector. There's, of course, Roth for 57B, but again, your plan has to offer the ability to contribute Roth in the first place.

John Biedenstein: And one thing that has not passed yet: The government is supporting Roth contributions in some of the new legislation that's not proposed or not signed off yet. It is actually forcing certain contributions to be Roth in the future versus today.

The government is a big advocate of collecting those contribution taxes now and using them on everything in the budget.

Colin Day: The main reason I wanted to talk about Roth today with you, John, is because one of the things that is coming up more and more because of the down market is Roth conversion strategies. Right now, you may be reading (if you're an avid reader of financial planning blogs, of course, like myself) that there might be a unique opportunity right now to do more Roth conversions based on the fact that the price of the securities in your portfolios are likely at a relative low.

For example, if you've got an account, let's say a Roth IRA, to keep it simple. You have a hundred shares of ABC stock, and ABC company stock is trading for $10. So we have about $1,000 in the account. Well, if you decide to do a Roth conversion — this is the process where you're taking money that was once pretax like in a traditional IRA and moving it into a Roth — that $1,000 moving from one account to another becomes a realized event, so you are going to pay taxes and ordinary income tax brackets on that $1,000 as it shifts from one account to the other. But if markets are down as they are right now, and let's say everything is trading at a premium, let's say it's gone down 20%. So what used to cost you $1,000 to convert maybe only costs you $800 to convert. So we're in a unique situation where, although accounts are down (and we don't wish that upon anybody, of course. We want everybody to do really well in the market), we might see a lucrative opportunity to complete a Roth to take advantage of the fact that we're at a recent low. So within our IRAs, we can work with our client's tax preparers to make good decisions. The tax preparer provides advice on an appropriate amount and what to convert in the IRA account world. But we do run into, occasionally, some individuals interested in converting their pretax 401k dollars into Roth 401k. What do you think about that?

John Biedenstein: Making the Roth conversion and doing it within a 401k plan, you have the same ability to do it within an IRA. I'm not an advocate of allowing Roth conversions within a 401k for one simple reason. It's because of that tax burden. Colin's exactly correct. That tax burden is lesser today just because of the market conditions than it was maybe six months ago or even a year ago. So it would be a lesser tax burden. You're doing that within a 401k plan. The participant has to always remember, "I'm gonna get a 1099 and have to pay taxes on this in the future." A lot of times, if you have those funds to pay those taxes outside of the qualified plan, it's great. But if you don't, you're going to have to make a withdrawal from the 401k to pay those taxes again. So it becomes a little bit more of a burden where you end up drawing out more money than you wanted to because of the Roth conversion in the taxable consequences of this. And I know Colin can go through an example of that. We worked with someone that ran into that, but you have those same capabilities of doing that within an IRA.

Colin Day: And what John was alluding to, I was directed to one of our participants in one of our 401k plans who was interested in doing a Roth conversion, and it was not an insignificant amount of money that this individual was interested in converting. It was in six figures. We talked through the tax ramifications and what that means. Adding a hundred thousand dollars plus onto your income can not only push you up in many tax brackets but like John was saying, trying to cover that tax liability by doing a tax withholding out of the 401k plan will necessitate taking even more money. So we might not be talking about, say, a hundred thousand dollars in the conversion, but maybe, to also prepay some of those taxes, take another $20,000 more for not only federal taxes, but also possibly for Illinois, Missouri, or any other state tax withholding. So there's a major consideration there.

And the result of the conversation I had with this individual is that we didn't convert nearly as much as the first discussion because after we had the conversation about if it was appropriate or not, it just came about that it wasn't going to be a good idea for this particular individual.

And ultimately, it does come down to your financial advisor. It comes down to your tax preparer to help you facilitate but then also understand the tax ramifications of what you would want to do. So, of course, we always suggest talking to somebody before making a decision like that, especially your tax professional.

John Biedenstein: As these Capital Conversations play out, the reality is these are very important things to consider in your full financial package, especially when you get closer to your retirement. I can put myself in the basket of someone who's been a long-tenured participant in a 401k plan, and I have always tended to make those contributions where I get them: before-tax traditional contributions. I get the tax benefit of making the contribution, but then I let my money grow for years and years and years. And all those company contributions that have been made are also in that taxable bucket.

I find myself and others with long-tenured participation in plans with all your eggs in one basket, which is that taxable bucket. So doing a conversion could be a great strategy. Also, even if you've been a participant for a long time and you're very comfortable, by transitioning some of those contributions into Roth contributions for your future and opening up that Roth bucket so that in retirement, you have those funds to pull in when something happens and you have an unexpected expenditure. Maybe you own a home, and it's a new roof you have to replace, or maybe it's something similar, but it's easier to pull those funds. In the example Colin just indicated, it's easier to pull those funds and say, "Okay, I'm going to take my $8,000 out of my Roth account to fix my roof" versus "I'm taking $10 grand because I have picked those top $2,000 worth of taxes out to pay for my $8 grand new roof.

Colin Day: The purpose of this particular conversation isn't to dissuade anybody from doing a Roth conversion, contributing Roth, or what have you. Each individual has unique opportunities available to them. But from our standpoint, it is looping in your financial advisor and your tax professional before making a decision, not only to perform something like a Roth contribution but even to have the conversation of, "should I be doing Roth contributions in my 401k? My 403B? My 457? My Roth IRA?" as opposed to just deciding to do something because their neighbor said the Roth is the better option. Or their coworker who's been doing this a little while suggests that one methodology is better than the other.

If you do have questions, I hope you'll reach out to our firm. If you do have specific questions about your personal situation, because that's really the best way to get the answers that you need as to whether or not Roth is correct for you or pretax is correct for you. But we do hope that what you take from this particular conversation is that Roth definitely is a diversifying instrument like John was talking about. It is definitely a different way of taking out money in the future that provides you with some flexibility so that you're not just taking everything out on a pretax basis. But there are some choices to be made, and there are trade-offs.

John Biedenstein: As Colin indicated, it's one thing to take advantage of the decline in the market in your account balance as of late. If you want to do this, it could cost less now than if you did it when your 401k is back to a 401k versus a "301k."

Colin Day: On that note, John, thanks for joining me today. We appreciate it. Until the next time. Take care.

Disclaimer: The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always, please remember investing involves risk and possible loss of principal capital.

Please seek advice from a licensed professional. Correct Capital Wealth Management is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Correct Capital Wealth Management and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Correct Capital Wealth Management unless a client service agreement is in place.

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